Tuesday, April 25, 2006

US$70 oil for the rest of the year?

Some of the economists at Morgan Stanley are saying that they are now expecting prices to stay around the US$70 mark for the rest of the year.

The price of crude has broken the $70/b line, crack spreads in the US are close to their post-Katrina peak and geo-political tensions are rising. We are thus revisiting the underlying fundamentals of our price baseline, extend it to 2008 and we look at alternative scenarios. In a nutshell, our conclusions are:

·We think that crude prices (WTI/Brent) are likely to range between $70 and $80/bl for the reminder of this year; we raise our 2006 annual average forecast from $61 to $73/bl (+19%);

·We believe that markets will remain tight next year, as new refinery capacity is coming slower than we had thought; We raise our 2007 annual average forecast from $48 to $68/bl (+43%);

·We continue to believe that price signals matter and that slower demand and stronger supply will ease tensions in the markets at some point. With the information we have in hand, we do not see that happening before 2008.

·In the short term, markets will remain highly sensitive to the mismatch between marginal demand and marginal supply, to possible supply-side shocks, political (Iran, Nigeria) or natural (Hurricane season)

I've been following their analysis of the oil markets for a couple of years now, and generally find them to be on the money.

What's particularly interesting is the mismatch between marginal supply and marginal demand. For the last couple of years, OPEC has been repeating like a mantra: oil demand may be high, but oil supply is in sync - it's just that refining bottlenecks mean that the oil isn't getting downstream in sufficient quantities. Most of the Gulfi states have taken steps to widen the bottleneck, and are investing heavily in refining capacity at home and abroad to help boost throughput (they're not averse to capturing a larger proportion of the added value that comes with refining and petrochems operations, either). They have also been oversupplying OECD countries so that they can build their inventories, which are now at record highs (as I pointed out last year).

OPEC is now taking on a much more worried tone. Prices prior to 2005 seemed to be largely driven by how much spare production capacity was left in the world, and the cartel tweaked production to keep OECD inventories large enough to sustain a supply shock but small enough to sustain reasonable prices. As prices increased, the linkage between production and pricing began to break down, and the cartel started building OECD inventories so that they could maintain a linkage between prices and inventories.

Now that linkage is breaking down too. Oil prices are continuing to rise despite high crude stocks, partially because of the refining bottleneck and partially because of the political risk premium. And OPEC isn't entirely sure what to do next:

"This price rise occurred despite the fact that the market continues to be well-supplied," OPEC official Adnan Shihab-Eldin told a meeting of the International Monetary Fund's policy committee on behalf of the oil cartel. . ..

He drew a distinction between the ample supplies on the crude side and tight supplies of refined products.

"The picture on the products side remains tight, given the persistently low levels of refinery spare capacity and more stringent products specifications" in the United States, the OPEC official said.

"As a result, any shortage caused by technical or logistic problems will continue to have a significant impact on the global market, affecting products prices and, consequently, crude oil prices," he added.

"Unfortunately the upward rising trend indicates that healthy market fundamentals have been unable to outweigh fears of possible future supply disruptions," he said.

He said the breakdown in the link between inventories and prices had led to an "urgent" need to identify more-reliable signals of price trends. He also said OPEC was concerned over the impact lofty oil prices could have on developing countries, and would monitor development closely.

For their part, the Americans appear to finally understand that OPEC has been doing what it can to bring prices down:

[US Energy Secretary Sam] Bodman said record oil prices of around $75 were causing great "dislocation" in the United States and the rest of the world but there was little producers could do. "We have encouraged producing nations to keep oil markets well supplied – I think they've done that. I would encourage them to do more if they can," he said. "We are in a situation where supply is roughly equal to demand today."

So what next?

Unusually for any future scenario, the long term is clearer than the short term. High oil prices have already sparked investment in refining capacity, which should over the medium term help to minimise throughput disruptions like the ones we have today. They have inspired massive investment in renewable energy - a finance journo friend tells me that at a recent conference he went to, the bankers were falling over themselves to find decent investment opportunities in renewables - which in the long term should bring energy prices down in the aggregate and allow more hydrocarbons to be re-purposed for petrochemicals. And they are bringing about the demise of environment-killing SUVs - no bad thing in my book.

The short term is fraught, however. Uncertainty regarding Iran, potential environmental shocks to the oil supply chain, have created lucrative information arbitrage opportunities to young traders (generally under 25 at the International Petroleum Exchange in London). Take, for example, the unexplained blast in Iran on Feb 16, 2005 - traders at the IPE "were disappointed with security for allowing [Greenpeace activists to invade the trading floor] just at a time when the [crude] market was pushing higher on the back of reports that a missile had been fired at Iran. I kept on trading electronically but I could see the [Greenpeace] guys coming on to the viewing gallery and then they were pushed back."

With near-instantaneous information flows, we are pushing up against the limits of human cognition to deal with the massive volume of data to parse and intepret. Enterprising young traders can exploit the commonly-held belief (true or false) that an attack on Iran is imminent to manufacture a brief spike in oil prices, which, in the full knowledge that it's a micro-bubble, they can make large amounts of money from by using a mixture of put and call options.

The great problem with that is that the media then seizes on the rise in oil prices as evidence of greater instability. A mutual feedback loop then kicks in, with the both the traders and the journalists assuming that the one knows something the other doesn't. Prices spiral upwards, fed by people arbitraging the emotional responses of their peers to over-hyped information.

This is where the self-fulfilling prophecy of all the doom-mongering kicks in. While in the short term the feedback loop appears to have reached some kind of Nash equilibrium - i.e. it makes little sense for market participants to change their strategies in the short term - ultimately the game is one of chicken, in that having both people not swerving (ie continuing to hype prices) is going to result in them crashing into each other (massive reductions in fuel consumption through fuel substitution, efficiency increases or just plain old global recession) and the equilibrium is unstable.

Of course, once that happens the doom-mongers will say 'we told you so all along'...

UPDATE -

I've just noticed that Bush has announced that environmental regulations are going to be relaxed and additions to the Strategic Petroleum Reserve deferred until the end of the summer.

US gasoline stocks have plummeted over the course of April. Lower sulphur limits were introduced this year - bear in mind that most of the spare oil capacity in the world is quite sour - and refineries in the US have been undergoing their usual seasonal maintenance cycle. Moreover, after a particularly warm, dry March, especially on the East coast, it seems that the US driving season may have started early.

Bush's decision is likely to take some of the edge off the markets by reducing the pressure on refiners, though how much of an edge it will take off is anyone's guess. I think that it may be a finger-in-the-dyke tactic - it will improve the fundamentals and may bring oil prices down a few clicks, but the spike activity is riding off risk speculation, particularly about Iran, and I don't see that changing just yet.